Public Finance and Public Policy Jonathan
CopyrightGruber
© 2010Third
Worth
Edition
Publishers
Copyright © 2010 Worth Publishers
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6.1 Acid Rain
Externalities in Action:
Environmental and
Health Externalities
6.2 Global Warming
6.3 The Economics
of Smoking
6.4 The Economics of Other
Addictive Behaviors
6.5 Conclusion
PREPARED BY
FERNANDO QUIJANO AND SHELLY TEFFT
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CHAPTER 6 ■ EXTERNALITIES IN ACTION: ENVIRONMENTAL AND HEALTH EXTERNALITIES
acid rain Rain that is unusually
acidic due to contamination by
emissions of sulfur dioxide
(SO2) and nitrogen oxide (NOx).
Acid rain is a classic negative production externality.
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6.1
CHAPTER 6 ■ EXTERNALITIES IN ACTION: ENVIRONMENTAL AND HEALTH EXTERNALITIES
Acid Rain
The Damage of Acid Rain
Raising the acidity of lakes and other bodies of water is just one way in
which acid rain affects the environment. Acid rain causes damage in a
variety of other ways as well:
► Forest erosion.
► Damage to property.
► Reduced visibility.
► Adverse health outcomes.
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6.1
CHAPTER 6 ■ EXTERNALITIES IN ACTION: ENVIRONMENTAL AND HEALTH EXTERNALITIES
Acid Rain
History of Acid Rain Regulation
1970 Clean Air Act Landmark
federal legislation that first
regulated acid rain–causing
emissions by setting maximum
standards for atmospheric
concentrations of various
substances, including SO2.
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6.1
CHAPTER 6 ■ EXTERNALITIES IN ACTION: ENVIRONMENTAL AND HEALTH EXTERNALITIES
Acid Rain
EM P I R I C A L E V I D E N C E
ESTIMATING THE ADVERSE HEALTH EFFECTS OF PARTICULATES
The estimates of the health costs of particulates come from a large empirical
literature on pollution and health outcomes. The typical approach taken in this
literature is to relate adult mortality in a geographical area to the level of
particulates in the air in that area.
The results from this type of analysis are suspect due to a key empirical
problem: the areas with more particulates may differ from areas with fewer
particulates in many other ways, not just in the amount of particulates in the
air.
Chay and Greenstone (2003) addressed this problem in an excellent quasiexperiment by examining the infant mortality rate, using the regulatory
changes induced by the Clean Air Act of 1970.
Their findings are striking: infant mortality declined substantially in areas
with regulation-induced reductions in emissions, relative to areas where
emissions were not mandated to fall.
Continued…
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6.1
CHAPTER 6 ■ EXTERNALITIES IN ACTION: ENVIRONMENTAL AND HEALTH EXTERNALITIES
Acid Rain
EM P I R I C A L E V I D E N C E
ESTIMATING THE ADVERSE HEALTH EFFECTS OF PARTICULATES
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6.1
CHAPTER 6 ■ EXTERNALITIES IN ACTION: ENVIRONMENTAL AND HEALTH EXTERNALITIES
Acid Rain
History of Acid Rain Regulation
The 1990 Amendments and Emissions Trading
SO2 allowance system The feature of
the 1990 amendments to the Clean Air
Act that granted plants permits to emit
SO2 in limited quantities and allowed
them to trade those permits.
Has the Clean Air Act Been a Success?
Economists are best at laying out the costs and benefits of alternative
interventions and leaving it to others to decide if those interventions can
be called successful or not.
Clearly, the Clean Air Act, particularly after the 1990 amendments, has a
lot to recommend it.
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6.2
CHAPTER 6 ■ EXTERNALITIES IN ACTION: ENVIRONMENTAL AND HEALTH EXTERNALITIES
Global Warming
greenhouse effect The
process by which gases in
the earth’s atmosphere
reflect heat from the sun
back to the earth.
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6.2
CHAPTER 6 ■ EXTERNALITIES IN ACTION: ENVIRONMENTAL AND HEALTH EXTERNALITIES
Global Warming
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6.2
CHAPTER 6 ■ EXTERNALITIES IN ACTION: ENVIRONMENTAL AND HEALTH EXTERNALITIES
Global Warming

APPLICATION
The Montreal Protocol
 An excellent example of international cooperation is the Montreal Protocol of
1987, which banned the use of chlorofluorocarbons (CFCs).
 As with global warming, this was a potentially enormous long-run problem.
 Unlike global warming, the CFC problem was showing itself immediately and
urgently: by the 1980s, a 25 million square kilometer hole had opened in the
ozone layer over Antarctica!
 This hole spurred the international community to action, and in September
1987, the Montreal Protocol was adopted, aiming for complete phaseout of
specified chemicals (mostly CFCs and halons) according to specified schedules.
 The result is that scientists predict the hole in the ozone layer will begin to
recover and return to normal around 2050.
It may take some type of exciting, newsworthy event to spur action on global
warming, which will not be solved for centuries after emissions are greatly reduced.
If the world waits for a crisis to spur us into action, it may be too late.

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6.2
CHAPTER 6 ■ EXTERNALITIES IN ACTION: ENVIRONMENTAL AND HEALTH EXTERNALITIES
Global Warming
The Kyoto Treaty
International conferences to address the problem of global warming began
in 1988. The peak of activity was a 1997 meeting in Kyoto, Japan.
After intense negotiation, the 38 industrialized nations agreed to begin to
combat global warming by reducing their emissions of greenhouse gases
to 5% below 1990 levels by the year 2010.
These goals were written into a treaty that has since been ratified by 35 of
the 38 signatory countries, and that went into effect in early 2005.
A notable omission from the ratification list is the United States, which
has shown no interest in signing on to this level of emissions reduction.
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6.2
CHAPTER 6 ■ EXTERNALITIES IN ACTION: ENVIRONMENTAL AND HEALTH EXTERNALITIES
Global Warming
Can Trading Make Kyoto More Cost-Effective?
international emissions trading
Under the Kyoto treaty, the
industrialized signatories are
allowed to trade emissions rights
among themselves, as long as the
total emissions goals are met.
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6.2
CHAPTER 6 ■ EXTERNALITIES IN ACTION: ENVIRONMENTAL AND HEALTH EXTERNALITIES
Global Warming
Can Trading Make Kyoto More Cost-Effective?
 FIGURE 6-3a
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6.2
CHAPTER 6 ■ EXTERNALITIES IN ACTION: ENVIRONMENTAL AND HEALTH EXTERNALITIES
Global Warming
Can Trading Make Kyoto More Cost-Effective?
 FIGURE 6-3b
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6.2
CHAPTER 6 ■ EXTERNALITIES IN ACTION: ENVIRONMENTAL AND HEALTH EXTERNALITIES
Global Warming
Can Trading Make Kyoto More Cost-Effective?
Participation of Developing Countries
By the year 2030, developing nations will produce more than half of the
world’s emissions, with China and India leading the way.
It is much cheaper to use fuel efficiently as you develop an industrial
base than it is to “retrofit” an existing industrial base to use fuel
efficiently. By some estimates, if we had an international trading system
that included developing nations, the cost to the developed world of
complying with the Kyoto treaty would fall by a factor of four.
The developing nations wanted no part of that argument, however. They
pointed out, rightly, that the problem that the world faces today is the
result of environmentally insensitive growth by the set of developed
nations.
Why should they be forced to be environmentally conscious and clean
up the mess that the United States and other nations have left behind?
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6.2
CHAPTER 6 ■ EXTERNALITIES IN ACTION: ENVIRONMENTAL AND HEALTH EXTERNALITIES
Global Warming
What Does the Future Hold?
Developments since the Kyoto treaty of 1997, in particular the decision of
the United States to reject the Kyoto treaty, do not bode well for short-term
agreement on how to combat the problem of global warming.
Recent evidence suggests that the nations of the world can come together to
combat a global environmental threat, but only when that threat is urgent.
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6.2
CHAPTER 6 ■ EXTERNALITIES IN ACTION: ENVIRONMENTAL AND HEALTH EXTERNALITIES
Global Warming

APPLICATION
Congress Takes On Global Warming
Under the American Clean Energy and Security Act (ACES), there would be lower limits
on the amount of emissions allowed, and firms could comply with the tighter targets in a
number of ways:
 They could reduce their emissions.
 They could continue emitting pollutants up to the amount of their purchased
emissions permits.
 They could purchase pollution credits to offset their emissions.
The ACES Act drew criticism from several sources:
 Those against raising the cost of energy production, since emitting firms would now
either need to buy permits, buy credits, or undertake other expensive actions to
reduce their emissions.
 Those who felt that the full value of the allowances should be rebated to consumers,
and not simply given back to the polluting industries.
The prospects for the ACES Act in the Senate are unclear; it is also unclear that the bill
will prove a meaningful step towards lowering the risk of climate change even if it passes.

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6.3
CHAPTER 6 ■ EXTERNALITIES IN ACTION: ENVIRONMENTAL AND HEALTH EXTERNALITIES
The Economics of Smoking
All externalities are not large-scale environmental problems. Some of the
most important externalities are local and individualized. Many of these arise
in the arena of personal health, and one of the most interesting is smoking.
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6.3
CHAPTER 6 ■ EXTERNALITIES IN ACTION: ENVIRONMENTAL AND HEALTH EXTERNALITIES
The Economics of Smoking
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6.3
CHAPTER 6 ■ EXTERNALITIES IN ACTION: ENVIRONMENTAL AND HEALTH EXTERNALITIES
The Economics of Smoking
The Externalities of Smoking
 TABLE 6-1
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CHAPTER 6 ■ EXTERNALITIES IN ACTION: ENVIRONMENTAL AND HEALTH EXTERNALITIES
The Economics of Smoking
The Externalities of Smoking
Increased Health Costs from Smoking
actuarial adjustments Changes
to insurance premiums that
insurance companies make in
order to compensate for expected
expense differences.
Externalities can be financial as well as physical. My smoking creates an externality
because the social marginal benefit of my consumption of cigarettes is below my
private marginal benefit by the extra amount that my coworkers have to pay for
insurance.
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CHAPTER 6 ■ EXTERNALITIES IN ACTION: ENVIRONMENTAL AND HEALTH EXTERNALITIES
The Economics of Smoking
The Externalities of Smoking
Workplace Productivity
There are many reasons why smokers may be less productive in the
workplace: they may require more sick leave or more frequent breaks
(for smoking) when at work.
Fires
Smokers are much more likely to start fires than nonsmokers, mostly
due to falling asleep with burning cigarettes.
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CHAPTER 6 ■ EXTERNALITIES IN ACTION: ENVIRONMENTAL AND HEALTH EXTERNALITIES
The Economics of Smoking
The Externalities of Smoking
The “Death Benefit”
An interesting twist on the measurement of smoking externalities is
presented by the positive externalities for the taxpayer by the early
deaths of smokers.
Through the existence of the Social Security program, smokers benefit
nonsmokers by dying earlier.
Externality Estimates
secondhand smoke Tobacco
smoke inhaled by individuals in the
vicinity of smokers.
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CHAPTER 6 ■ EXTERNALITIES IN ACTION: ENVIRONMENTAL AND HEALTH EXTERNALITIES
The Economics of Smoking
The Externalities of Smoking
What about Secondhand Smoke?
The damage done to nonsmokers by breathing in secondhand cigarette
smoke is a classic externality because individuals do not hold property
rights to the air. Without clearly defined property rights, complete
Coasian solutions to this problem are not available.
Yet the costs of secondhand smoke are not easily added to the list of
external costs we have noted for two reasons:
• There is considerable medical uncertainty about the damage done by
secondhand smoke.
• Most of the damage from secondhand smoke is delivered to the
spouses and children of smokers.
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CHAPTER 6 ■ EXTERNALITIES IN ACTION: ENVIRONMENTAL AND HEALTH EXTERNALITIES
The Economics of Smoking
Should We Care Only About Externalities, or Do “Internalities”
Matter Also?
Youth Smoking
Of all adults who smoke, more than 75% begin smoking before their
nineteenth birthday.
The traditional model of smoking presumes that the decision to initiate
this addictive behavior is made with a fully rational trade-off in mind
between current benefits and future costs.
There is some evidence that this monumental decision may not be made
in the forward-looking fashion required by rational addiction models.
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6.3
CHAPTER 6 ■ EXTERNALITIES IN ACTION: ENVIRONMENTAL AND HEALTH EXTERNALITIES
The Economics of Smoking
Should We Care Only About Externalities, or Do “Internalities”
Matter Also?
Adults Are Unable to Quit Smoking Even if They Have a Desire
to Do So
Another key fact about smoking is that many adults who smoke would like
to quit but are unable to do so. Consider the following facts:
► Eight in ten smokers in America express a desire to quit the habit, but
many fewer than that actually do quit.
► According to one study, over 80% of smokers try to quit in a typical
year, and the average smoker tries to quit every eight and a half months.
► 54% of serious quit attempts fail within one week.
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CHAPTER 6 ■ EXTERNALITIES IN ACTION: ENVIRONMENTAL AND HEALTH EXTERNALITIES
The Economics of Smoking
Should We Care Only About Externalities, or Do “Internalities”
Matter Also?
Adults Are Unable to Quit Smoking Even if They Have a Desire
to Do So
self-control problem An
inability to carry out optimal
strategies for consumption.
commitment devices
Devices that help individuals
who are aware of their selfcontrol problems fight their
bad tendencies.
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CHAPTER 6 ■ EXTERNALITIES IN ACTION: ENVIRONMENTAL AND HEALTH EXTERNALITIES
The Economics of Smoking
Should We Care Only About Externalities, or Do “Internalities”
Matter Also?
Implications for Government Policy
internality The damage
one does to oneself
through adverse health
(or other) behavior.
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6.4
CHAPTER 6 ■ EXTERNALITIES IN ACTION: ENVIRONMENTAL AND HEALTH EXTERNALITIES
The Economics of Other Addictive Behaviors
While cigarette smoking is a particularly interesting application, it is by no
means the only health behavior where externalities (or internalities)
potentially cause market failure.
Drinking
On the one hand, the externalities associated with alcohol consumption
are much larger than those associated with smoking. This is largely
because the major externality associated with alcohol consumption is
damage due to drunk driving.
The internalities due to drinking may be much smaller than those due to
smoking, however. Drinking in small quantities, while it may impair one’s
driving, may actually be good for long-run health.
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6.4
CHAPTER 6 ■ EXTERNALITIES IN ACTION: ENVIRONMENTAL AND HEALTH EXTERNALITIES
The Economics of Other Addictive Behaviors
Illicit Drugs
In the United States, the government regulates illicit drug activities by
prohibiting its consumption, subject to criminal penalty. This is a
particularly interesting case because most of the externalities associated
with illicit drugs arise because of their illegality.
Legal consumption of some illicit drugs is likely to have much lower
externalities than consumption of alcohol.
As the famous economist Milton Friedman wrote in 1972, in advocating
the legalization of drugs, “The harm to us from the addiction of others
arises almost wholly from the fact that drugs are illegal. A recent
committee of the American Bar Association estimated that addicts commit
one-third to one-half of all street crime in the U.S. Legalize drugs, and
street crime would drop dramatically.”
Despite this argument, drug legalization remains a radical idea in America
and in most nations.
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6.4
CHAPTER 6 ■ EXTERNALITIES IN ACTION: ENVIRONMENTAL AND HEALTH EXTERNALITIES
The Economics of Other Addictive Behaviors

APPLICATION
Public Policy toward Obesity
Obesity has both enormous externalities and internalities. Addressing obesity
through tax policy is much more difficult than addressing smoking because, while
every cigarette is bad for you, clearly some food consumption is good for you!
 The major focus of policies to address obesity has been through improved
information and targeting of the substances most closely linked to obesity.
 There has also been an aggressive effort to phase out the usage of artificial
“trans-fats”.
 A number of states are considering taxes on sugary sodas, and some have
proposed this as a revenue source to finance expansion of health insurance
coverage in the United States.
 In a more aggressive approach, some states have moved directly to charging
individuals for being obese or for not caring for their weight.
 Other states and employers are providing financial incentives for employees to
enroll in wellness programs that will help them manage their weight.

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CHAPTER 6 ■ EXTERNALITIES IN ACTION: ENVIRONMENTAL AND HEALTH EXTERNALITIES
The Economics of Other Addictive Behaviors
Summary
Regulating other health behaviors raises many similar issues to those we
raised for smoking.
For drinking and obesity, however, existing taxes are already so far below
the level of negative externalities that assessing the role of self-control
problems and internalities is not critical: virtually any economic model
would imply that if these externality calculations are correct, taxes should
be higher.
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6.5
CHAPTER 6 ■ EXTERNALITIES IN ACTION: ENVIRONMENTAL AND HEALTH EXTERNALITIES
Conclusion
Public finance provides tools to help us think through the regulation of
regional externalities such as acid rain, global externalities such as global
warming, and even the “internalities” of smoking.
Careful analysis of public policy options requires discriminating truly
external costs from costs that are absorbed through the market mechanism,
understanding the benefits and costs of alternative regulatory mechanisms to
address externalities, and considering whether only externalities or also
internalities should count in regulatory decisions.
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